Past Performance: One Of The Worst Ways To Choose Your Investments

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Check out any mutual fund advertisement, and right at the top of the ad you invariably find a massive chart of past performance figures. Look way down below, and in very small print you’ll also see this bit of wisdom: “Past performance is not indicative of future performance.”

There’s a reason fund companies have to run that mandatory disclaimer: the past rarely does predict what comes next. In fact, many funds that have exceptional returns one year suffer correspondingly in the next period. Yet most investors tend to rely almost solely on past performance when making decisions. The fund companies do know that, however: they’re aware that a fund with a five-star rating and a great record can count on receiving an avalanche of money.

You can’t really blame them: it must be hard to resist advertising their performance when they’re so handsomely rewarded for it. We’re all willing to hand over fortunes to companies that did something great last year—after all, it’s only human nature to extrapolate whatever happened last week into the future.

Back in March 2009, at the pit of the bear market, the media and newspapers were filled with stories of how we were only just beginning to see all the terrible problems that lay ahead. At the lowest point of the market, redemptions of equity funds and the sale of stock holdings had reached all-time highs. Investors clearly thought that if last year was bad, next year was certainly going to be bad as well.

Big surprise: the opposite turned out to be the case. Most stock-market indices gained 50% or more in the following months, and stocks enjoyed the steepest and fastest recovery since the 1930s.

When something as precious as our life savings is on the line, we can all be forgiven for making desperate attempts to see into the future. Sometimes we even believe we’ve found a seer to help us. There’s always someone who seems to have been able to spot the crash (or the boom) in advance; and it’s easy for us to believe that they know something we don’t.

Well, that’s one option: maybe they did know something—or maybe they were just lucky guessers. The catch is, it’s only obvious in retrospect whether events proved them right. Until that time, they were just another voice crying out in the wilderness. Only if the events they predicted actually came to pass did the chain of events all of a sudden look obvious. But we have to remember: in advance of the facts, it’s hard to locate these financial oracles among the thousands of differing opinions and forecasts out there.

Past performance is one of those “facts” that seem to dispel uncertainty. If they did it last year, they must know how to do it again this year, right? Well, maybe. Or then again, maybe that top-performing asset manager had been buying a favoured asset class (such as small-cap oil stocks) for two decades now—and finally, their ship came in. Last year’s results could be the end result of a long trend; or it could be simple chance. If I flip a coin and get “heads” ten times in a row, that doesn’t mean I’m a star; it just means I’m lucky. The next flip is still a 50/50 proposition.

From everything I’ve said here, you might get the idea that past performance is completely irrelevant. I don’t mean to imply that. It’s just that on its own, that metric doesn’t tell you enough to make good decisions about future performance. In fact, if you want to buy low and sell high, common sense would tell you that it’s better to buy after a bad past performance, not after a good one.

The good news for investors, we’ve all just witnessed several really bad performances. The bad news: knowing this will likely keep most investors on the sidelines. The good news again: that widespread reluctance will reward those who do take the plunge.

The bottom line: don’t completely discard past performance from your decision-making process. Just acknowledge that it’s only one of many factors—and less important than several others, such as clear objectives, asset allocation, diversification, and low-cost portfolios.

Alan MacDonald an investment advisor with Richardson GMP Limited, helps investors with over $500,000 of assets make smart decisions about money. Alan is the co-author of “The Copperjar System, Your Blueprint for Financial Fitness” available on Amazon.

For more information please visit www.alanmacdonald.ca or email Alan at Alan.Macdonald@RichardsonGMP.com.

All material by Alan MacDonald, Investment Advisor at Richardson GMP Limited. The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates.

Richardson GMP Limited, Member Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.

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